Making It In The Stock Market

The stock market has been all over the news this week, because of a quixotic trading flash mob which rose up out of Reddit to cause losses to hedge funds and drive up the stock price of GameStop.  What is going on?

GameStop is, of course, a chain of brick-and-mortar retail stores which sells video games and related merchandise, and which buys trade-in video game cartridges back and then resells them.  During the last decade, their sales have flattened and then begun to decline, due not only to the overall decline in brick-and-mortar retail but also to the fact that many current gaming systems can buy new games online and download them without ever purchasing a cartridge.  By last fall, their stock was trading at around $4 per share and they were losing money.  However, there was a range of consensus of the company's direction.  Wall Street analysts had published price targets for the stock ranging from $3.50 to $33.  After a series of executive turnovers, the company had a new CEO and Michael Burry of "The Big Short" fame had invested in several million shares of the company and was pushing for various changes to improve the business.

Against this background, a big name user in a Reddit subreddit known as r/wallstreetbets began posting back in 2019 about how he had invested just over $50,000 in call options (bets that a stock will increase to above a target price by a specific date -- in this case the target was $8 per share and the due date was January 2021) on GameStop.  This user, whose somewhat colorful handle can be abbreviated DFV, posted repeatedly about his investment, and there was considerable excitement as the stock did indeed begin to rise, passing his target price in Sept 2020 and continuing up.  

At some point, two additional things happened: Lots of other people (r/wallstreetbets has several million users) wanted in on the action, and it became known on the subreddit that several large hedge funds had taken out shorts against GameStop.  

A short is a financial instrument where the buyer of the short borrows a stock at the current price and sells it, committing to give the stock back (called covering the short) at the market price of some future date.  So, if you short 100 shares of ACME when it's trading at $10 per share, and you cover when the share price has dropped to $5, you make $500.  If you shorted at $10 and the stock became totally worthless, you'd make $1000.  However, if you short at $10 and ACME shares go up to $100, your losses are $9000.  So a short can be very risky.  Your upside is limited and you could have infinite downside.  Shorting is also sometimes seen as a very negative thing to do.  After all, you're profiting off the company doing badly.  Back in the 2007/2008 banks asked (and the government agreed) for a temporary ban on shorting financial stocks, because hedge funds were making money betting that the big banks would go down.  (This didn't help -- the stocks continued to go down because the banks were teetering on the edge of insolvency, and it was only the bailout that saved them.)

What happened next is what created the huge news story.  Huge numbers of investors from reddit began buying GameStop shares, bidding up the price.  As they drove up the price, this made the hedge funds which had shorted GameStop lose money.  And the goal was not just to make them lose money, but to make them cover their shorts, realizing their losses.  If the hedge funds covered their shorts (by buying shares) this would drive up the price of the stock still further in an effect called a "short squeeze".  

Step one: destroy hedge funds
Step two: profit

Of course, there's a step three out there as well, which people don't seem to be thinking about as much: The price of GameStop collapses.  

Why?

At root, GameStop is a company which is not likely to grow dramatically in the future.  In 2020 it had $6.5B in sales and lost $471M.  It hasn't made a profit since 2018.  Even if current management manages to turn it around, it'll still be a retail chain with limited growth potential.  How crazy is the current valuation of GameStop?  As of today GameStop had a market cap (the total value of all outstanding shares) of $22B.  That makes it just short of the supermarket chain Kroger, with a market cap of $26B.  But by comparison, Kroger had sales of $122B in 2020 and profits of $1.7B.  Is there any reason to think that GameStop will become anywhere near as big or as profitable as Kroger?

Stocks sell for what people are willing to pay for them.  Usually, what people are willing to pay for them is in some way connected to how much the underlying company makes now, or how much people imagine it may make in the future. Clearly, this can at times result in wild swings, because people are constantly reassessing what they believe the future will be like.  There is nothing magically true about market prices.  But in the long run, companies that grow in revenue and profitability tend to increase in share price, while those that shrink tend to fall.  

Once people cease to desire to own GameStop stock for the online glory of it, the value will fall to the level which is justified by the company's actual prospects.  If I had to guess, that level is almost certainly less than 1/10th the $328 at which the stock closed today.  And of course, that suggests a rather uncomfortable fact: a lot of people have bought the stock at $350 or $200 or $100, etc. and all of those people are going to lose a lot of money.  So while I have no particular sympathy for the hedge funds which have suffered massive losses on their shorts against GameStop (they should have know they were playing a very risky game) I'm concerned about the people who are portraying this as some sort of a huge uprising which shows that the "little guy" can make money on the stock market just like the pros.  It is true that some people will come out of this having made a lot of money.  It is true that manipulating stock prices through the madness of herd behavior is something that pros had succeeded in doing in the past.  But in the long term, making smart moves during panics is not the way to make money on the stock market.  The way to make money on the stock market is to identify companies that will grow to become a lot bigger and more profitable than they are now, and to invest in those companies.  

Don't believe me?  Allow me to tell a story.

Back in 1996 I was heading into my senior year of high school, and I was 18 years old.  I was fascinated by what I'd read about the stock market, and I was a deep, deep believer in Mac computers.  I'd just bought myself one of the first color PowerBook laptops, planning to write a novel on it during my senior year of high school and then take it to college with me.  (I did do both of these things.)  Apple was not doing well financially at that time.  It was during the period after Steve Jobs was fired (he returned in 1997.)  But I was convinced that Macs were wonderful and that somehow Apple would prosper.  So I raided my college savings for $2,000 and invested that money via an online brokerage in Apple stock.  If you adjust for the splits that have happened since that time, the price of that stock was about $0.20 per share.  

By 1999 that $2,000 had grown to about $10,000, and I thought I was pretty brilliant.  I sold $3,000 of the stock and bought my first car, a 1989 Honda Accord, so I could get a better paying job off campus during my senior year of college.  And I "balanced" my portfolio by selling some more of the Apple stock and buying shares in other companies.  Looking back, those decisions cost me a lot of money, but I didn't have any kind of foreknowledge.  

In 2002, as we were a young married couple in Los Angeles expecting our first baby and struggling with college debt and high rent, I was advised to sell the stock (which had languished despite the recent introduction of the first iPod) and get out of debt.  I did sell the stock, and I did pay off our credit card debt (it would be another decade before we cleared our student debt) but I moved some of the remaining money into a Roth IRA and put it back into Apple stock.  And one other thing.  I had an argument with by boss about whether Amazon would ever make a profit, or if it was another .com that would go bust.  I was the one who believed in Amazon, because I'd been a loyal customer for a couple years.  So I bought a few hundred dollars of Amazon stock.  At the time, it was trading for about $20/share.

During most of the intervening years, I ignored that Roth IRA.  Occasionally I messed around with it, balancing the two main stock positions against an S&P 500 fund and occasional other stocks I was interested in.  Looking back, all those "balancing" positions were bad in the long run, but again, I had no way of know thing.  

When the pandemic hit, I sold virtually all of my stock in mid February, thinking that the stock market would go down by 50% of more.  It went down a lot, but not that much.  In the process, I made some dumb decisions trying to temporarily money it into something "pandemic proof" (during March, practically nothing was pandemic proof) when I should have just kept it in cash.  In the end, I put money back into Apple and Amazon, but not nearly as much of it.  I took some time to read and research, and I decided to put 40% of my money into large, mostly tech stocks (with a lot of that being Apple and Amazon again, but some Google, Facebook, Tesla, etc.) another 40% into stocks and funds which (at the prices I was able to pick them up in the spring) paid dividends ranging from 7% to 15% of the what they cost me; and the last 20% into "small cap" stocks which currently had market caps under $10B but had the potential to grow 10x or more in the coming decade.  My theory was that while I had benefitted from the massive growth of Apple and Amazon, with both of these companies being worth more than a trillion in total capitalization, it was unlikely that they'd be growing by powers of ten in the future.  Apple, Amazon, Microsoft, and Google may grow faster than the economy as a whole in the future, but they are now such a big part of the economy they can hardly grow multiple times faster than the economy.  So I reasoned that I would need to start looking for the next big growth stocks.  And since I didn't have any particular insight this time (nor any guarantee of being lucky again) it seemed like it was best to go wider.  And my reason for putting 40% of the portfolio into high dividend stocks was that I wanted them to produce about five thousand dollars in cash every year which I could turn around and invest in new small cap stocks without having to sell the holdings I already had.  

I bring all this up not to argue that I am particularly brilliant, but rather to argue that one doesn't have to be particularly brilliant.  I made both picks out of brand loyalty, thinking they were well run companies that had a great product that would do better in the future.  Apple stock has increased 65880% since I first bought it.  Amazon has increased 16085%.  I did a lot of things which worked against that growth.  I took money out, "rebalanced" into an S&P 500 fund, and invested money in companies that went out of business such as SpaceDev and MP3.com  But even so, the remains of that $2000 that I invested at age 18 were as of close of market today worth $162k.  (I have a separate 401k from my various jobs over the years which is invested more conservatively.)  Even with all that dilution, that's a 8000% increase.  For comparison, legendary investor Warren Buffet delivered a 4209% increase in Bershire Hathaway stock during his first 25 years on the market.  (I used that number because the last 25 years have been a more lackluster 999%, though even that is more than twice the increase of the S&P500 over that time.)  

Again, my point is not that I'm brilliant, because I'm not.  My point, rather, is this: the little guy investor does not need to join a roiling crowd to beat the market.  If the little guy does some solid research, invests in what he knows and believes in, follows the fundamentals, and ignores the temptation to get caught up in frenzies, he can outperform the market and even outperform the big institutional investors.  He won't turn huge profits inside of a month, but that's not generally how the stock market works.  

So I lay all this out transparently to say: You do not have to join an online swarm and manipulate the market to get ahead as a small investor.  Indeed, doing so puts you at risk of being one of the people holding the bag when the bubble pops.  Buy and hold solid companies.  Wait for the years to pass.  Do some intelligent maintenance.  Keep looking for the company which is still comparatively small (when I bought Apple and Amazon, both were under $10B in market cap) but which may grow huge.  That's really all it takes.  It's not that hard.  Please don't try do get in on a market manipulation scheme instead.  It's a lot harder to play that game right than it is to identify some basically solid companies and just let time pass.